Anatomy of a disaster

Kevin Chinnery |
Nov. 27, 2008

Who is to blame for the financial crisis?

A silent bank run was under way, not in queues on the street but in the back offices of banks and institutions as they refused to lend to each other. Instead, they hoarded their cash in case more of their transaction partners fell over, damaging their capital further. As interbank lending seized up, the economy was deprived of the credit it needed to function.

On September 19, fearing that a further shock would have unstoppable consequences, US Treasury secretary Henry Paulson proposed what was in effect a sovereign wealth fund in reverse, a $US700 billion plan to buy up worthless debt instruments to be sold when the markets recovered.

But on September 29, in a political stunner, the US Congress baulked at Paulson's rescue plan. At issue was popular resentment, ahead of national elections, that Wall Street was being bailed out while America's Main Street was losing the roof over its head. Wall Street suffered its biggest point loss in history - 770 points - to remind Congress members of the impact of the banking collapse on the real economy - and their electorates.

Congress finally passed the $US700 billion rescue plan on October 1. By then, the US was being criticised for incremental efforts that had not landed a decisive blow on the problem - with doubts rising whether the Paulson strategy of easing pressure on banks by buying up toxic debt from the credit system could be made to work.

De facto semi-nationalisation

Free-market ideology held the US back from the alternative: a direct injection of capital into the banks themselves, or de facto semi-nationalisation.

The weekend of October 11 and 12 was a tense one with meetings of the Group of 20 leading economies and Group of Seven leading industrialised nations in Washington as the world waited for action.

In the United Kingdom, Prime Minister Gordon Brown returned from Washington on October 13 and committed potentially almost a third of the UK's annual gross domestic product - compared with 5 per cent of GDP the US was spending on its bail-out - to strike directly at threats to bank solvency and liquidity. "There is no plan B," Brown warned.

His widely copied proposals tackled simultaneously the three big problems facing banks: a shortage of capital because of the huge losses and write-offs of assets; the inability to finance loans not covered by deposits because medium-term commercial paper markets could not be used; and no overnight liquidity because of the closure of short-term money markets.

Within hours, the Netherlands, Spain, Germany and Austria began committing $US2.6 trillion to guarantee bank loans and take stakes in key banks.